Crunchtime: where next for Tesla

Tesla has reached the most critical point in its 15 year history, and is under pressure to make the company sustainable after years of exponential spending that is testing the patience of investors. Tesla’s latest earnings show improvement, but has Elon Musk done enough to reassure shareholders?

The stakes have never been higher for Tesla. While customers and investors remain loyal to Elon Musk’s long-term vision of revolutionising the automotive industry with its collection of electric vehicles, their confidence in the CEO’s ability to deliver his own short-term targets is being tested.

Without simplifying the complexity of Tesla, the immediate problem is relatively simple. The company started the year with $3.4 billion in cash and that has plunged to $2.7 billion by the end of March. Tesla is still burning cash, and Musk has reiterated his promise not to ask investors for more money by raising further equity. As a result, Tesla is now in a race to make more money than it spends before the current cash pile dries up.

The key to financial sustainability lies with the newest and most affordable car in the Tesla range, the Model 3. It quickly abandoned its original target to produce 10,000 Model 3’s each week when it was launched less than a year ago, and the company has had to learn fast. Still, Tesla is now struggling to achieve half of that volume, and investors are worried it can’t ramp up in time before the cash is exhausted.

Tesla’s annual budget this year will be below $3 billion, compared to the $3.4 billion it spent last year, suggesting its bank account will be in a precarious position by the end of 2018. The company described itself as ‘very capex efficient’, after the latest results and Musk remained as confident as ever, responding to one question probing where spending had been specifically cut as ‘dry’, before stating: ‘Next question’ – that turned out to be one on how reservations for the Model 3 had been affected by recent news, which Musk also shunned.

Musk has reiterated that Tesla will begin generating positive cash flow in the second half of this year, and therefore all the woes about cash are unfounded. However, as that is predicated on achieving consistent production rates, investors are right to be nervous because Tesla has consistently failed to deliver its targets. Whether that’s the result of over-promising or under-achieving is up for debate. Tesla needs to get weekly output at its Fremont plant up to at least 5000 Model 3s each week to generate positive cash flow, but as Tesla is not even producing half of that, it is easy to understand why shareholders are nervous.

Let’s dive a bit deeper into the problems rumbling on at Tesla and what is next for the company following its latest results.

How did Tesla perform in early 2018: first quarter earnings?

Tesla had already released an update in early April revealing that it delivered its best ever operational performance in the first quarter of 2018, and the financial update that followed was mixed. Tesla delivered revenue of $3.40 billion and an adjusted net loss of $3.35 per share, beating analyst expectations for revenue of $3.23 billion and a loss of $3.53. But Tesla’s quarterly loss was still its biggest on record, and investors couldn’t ignore the continuing rapid rate at which cash is flying out of the business.

Q1 2017

Q2

Q3

Q4

Q1 2018

Revenue

$2.70 billion

$2.79 billion

$3 billion

$3.29 billion

$3.40 billion

Gross profit

$667.9 million

$666.6 million

$449.1 million

$438.8 million

$456.5 million

Net Loss

($330.3 million)

($336.4 million)

($619.4 million)

($675.4 million)

$709.6 million

Per share

($2.04)

($2.04)

($3.70)

($4.01)

($4.19)

Cash at quarter-end

$4 billion

$3.04 billion

$3.53 billion

$3.37 billion

$2.67 billion

Tesla: Model 3 production

The all-important goal is getting consistent production of the Model 3 to over 5000 per week. Tesla has failed to hit targets, but is loosely aiming to hit that goal by the end of June. Failure to hit that rate, or at least very close to it, will not be well received by investors.

Production of the Model 3 reached new highs in the first quarter (Q1). Tesla has managed to get weekly production above 2000 for three straight weeks, the last of which recorded output of 2270. Unfortunately for Musk, the things he and Tesla have achieved over the last year are being overshadowed by the longer than anticipated ramp-up.

Tesla owns two of the biggest factories in the world. The Fremont plant produces the Model 3 (alongside the Model S and Model X) and the Gigafactory is all about batteries – and both have contributed to the bottlenecks that have stopped Tesla ramping up output as desired.

At Fremont, Tesla had to shut down production after it peaked, to optimise the line and carry out more work, with another shut down planned during the next two months. Tesla has had to rethink its automation plans. The firm’s original vision, which still holds true for the future, is to automate as much as possible. But for now it has realised that human hands are better designed for many tasks and that it had automated some ‘silly things’, which has led to a hiring drive.

Some welcome news is that the Gigafactory has caught up. Having previously struggled to make batteries as fast it does cars, Tesla has now pushed output up to over 3000 per week to outpace the manufacturing rate of the Model 3. At its peak hourly rate, battery production has even managed to exceed the 5000 target.

One line that Musk has become known for is: ‘manufacturing can only go as fast as the slowest moving part of the supply chain’, and the pioneer has publicly ran out of patience with the multitude of third parties that have become involved in Tesla’s production process.

Speaking to analysts after the results, Musk conceded the amount of third parties involved had ‘got out of control’, and said Tesla plans to restructure itself shortly. This, Musk said, means Tesla needs to ‘scrub the barnacles on that front – we have barnacles on barnacles’. If the delays have been down to external suppliers and partners, then Tesla will have to hope none of them are integral parts of the process and that they can either take that work back in-house or find a better replacement.

Although described as ‘very manageable’, Musk said the segment of the Model 3 production line that presents the biggest risk to reaching the 5000 goal was general assembly, followed by the paint unit.

Tesla: cash and finances

Despite the progress being made (and several promises not to do so), Musk is still being asked questions about Tesla raising equity later this year. In the past this has seen Musk raise his stake while the smaller shareholder base is diluted down. He could not have been clearer when questioned about whether it would be better to raise money now, when you want to, or before you have to.

‘I specifically don’t want to,’ he said. Musk himself knows that door is shut, and as far as he is concerned, he doesn’t need to go through that door anyway.

Debt has also peaked, ending last year at $9.63 billion and swelling further to sit at $9.98 billion at the end of March. This is why Tesla needs to be able to be self-sufficient.

If Tesla is to reach sustainable profitability then it needs to combine higher volumes with better margins. Progress is being made, but has been held back, partly because of fluctuations in commodity prices and the dollar. Tesla is tackling these headwinds in several ways, such as reducing the amount of cobalt it needs.

The introduction of the Model 3 last year took its toll on margins, and the aim is to get it back up to 25%. While Musk is aware time is not on his side at present, he also believes investors should be more encouraged by the quarter-on-quarter improvements achieved with the Model 3, as margins and production rates have consistently risen, instead of being disheartened for missing forecasts.

Here is Tesla’s automotive gross margin performance:

Q1 2017

Q2

Q3

Q4

Q1 2018

Reported margin

27.40%

27.90%

18.30%

18.90%

19.70%

Adjusted margin

19.70%

25%

18.70%

13.80%

18.80%

Musk said the margin should be around the 20% mark in the final quarter of this year, before reaching 25% in the middle of 2019, and ending next year in the high 20s.

Turning to the wider cash flow issue, Tesla said its overall gross margin will turn from slightly negative in the first quarter of 2018 to roughly breakeven by the third quarter, and then becoming ‘highly positive’ in the final three months of this year.

The amount Tesla has to do between now and the end of the year is mounting a lot of pressure on the third and especially the fourth quarter of 2018 – giving investors reason to argue that Tesla runs the risk of running out of electricity before it gets to the finish line.

A recent downgrade from Moody’s is another factor testing shareholder’s belief in Musk. The ratings agency, prior to the latest results, warned that Tesla faced another downgrade if cash continued to dwindle, and said the company would have to raise around $2 billion of equity before the year is up.

Tesla has cut its capital expenditure budget this year and seems to be heading more for a ‘grow-as-earn’ strategy. The company claims it has the ability to cut the budget further to further reassure shareholders that they won’t be cutting it too fine at the end of the year.

Musk and his team were vague regarding where the savings had come from, claiming it was working smarter, and therefore spending smarter. Production is increasingly moving toward a 24-hour, 7 day-a-week operation to help the company get more for its money, and Musk seems set on eventually having every aspect of production on this pattern, especially as capacity is squeezed.

Tesla has admitted it tried to automate too much, too quickly to start off with. Speaking about how some things are simply designed for human hands, Musk conceded the company had tried to automate some ‘silly things,’ such as the ‘Fluffbot’ – essentially a robot hand tasked with picking up fluff and putting it on the battery.

Interestingly, Musk and his team believe replacing its ineffective automation with workers will actually save the company money, contradicting the idea that Tesla’s hiring rally had been a big driver behind the amount of cash being burned. They argued that the cost of getting someone to manually place the ‘fluff’ was cheaper than paying a robot technician who, in the end, was having to service Fluffbot 24/7.

Tesla’s overall message? Improved production volumes at a lower cost.

Is Tesla going ahead with new models?

For those concerned with Tesla’s rate of spending, any talk of Tesla even considering its next product is hard to hear. There were reports that plans for the Model Y, an electric crossover vehicle, would be put on the backburner until everything was stable with Model 3, but Tesla confirmed it is pushing ahead.

Musk was clear, however, that current spending on Model Y is nominal compared to revenue, and said it wouldn’t start becoming material until next year, when Tesla should be cash flow positive.

It may seem strange to throw excitement behind a car that doesn’t exist yet when money is tight and thousands of customers are still facing a long wait for the Model 3 they have ordered. But Musk claims the Model Y will represent a ‘manufacturing revolution’, when Tesla would implement the many tough lessons it has learnt from the troublesome Model 3.

Investors will take this with a pinch of salt, but Musk did state that production of the Model Y could start in ‘early 2020’, rebutting reports it was to start any sooner. The more interesting revelation was that the Model Y will not be built at Fremont. Tesla’s operations are built around having everything under one roof, or in this case a few very big roofs. Musk stated he didn’t know where the Model Y would be built, but was pretty sure it wouldn’t be at Fremont, adding that the factory is already brimming at the seams.

Where does Tesla go from here?

The market will be watching Tesla like an eagle eyes its prey as we move forward in 2018, and shares are likely to be sensitive as insights and reports of Tesla’s performance feed through over the coming months. The next report will provide investors with an update on progress made at the midway point of the year, when the focus will be on whether it is building 5000 Model 3’s each week and what impact that has had on its finances.

No other carmaker has come close to ramping-up production of an entirely new model in the timeframe that Tesla is aiming for. Many, including Musk in some respects, would argue against comparing Tesla to others in the market and point to the astounding progress it has already made in a matter of months with the Model 3. Others will argue that Tesla, like everyone else, can’t do it, and is running before it can walk.

But Musk is more one to leap before he can crawl and, to take a leaf out of his book, there is much to cheer. It is unclear whether the last few months of negative publicity has knocked reservations for the Model 3, but even if it has the fact remains that demand far outweighs supply – and is likely to stay that way for a while. Notably, the deposits customers pay Tesla in advance (years in some cases) is an important inflow of cash for Tesla at present, so any substantial drop in interest or demand would have an impact.

Tesla claims the Model 3 is the second most popular sedan of its class in the US at present, despite the bottlenecks of getting them into the market, narrowly behind the Mercedes C Class. The Model 3 is thought to have over 25% market share, and Musk said that could climb to 30% to 40% later this year, and possibly even over the 50% threshold.

Tesla share price: a technical analysis

The stock has continued to stumble since it hit its highs back in the summer of 2016, at $389. The next target on the downside would be the rising trendline from the 2016 lows, which would suggest a drop towards $260. Below this, $244.71 (the low from March 2017) comes into play. We have seen lower highs since September 2017, with $362 marking the limit of upside in Q1 this year. A move above $340 is needed to break the downtrend line.

Conclusion: it’s crunchtime for Tesla

It seems 2018 will prove a decisive year for Tesla and Musk. While many continue to believe in Musk’s vision for the future, their confidence in his ability to deliver his own goals over the shorter term is constantly being knocked and now time is running out.

Every day that Tesla loses innovating because it has to address issues on the production lines represents a day it has lost to its competitors. Tesla worked hard to earn its early lead over its fuel-guzzling competitors, and has ensured it leads as the market standard, but nearly every automaker in the world is working on an electric car at present and many of them are catching up.

Well-justified doubt will remain, but there is another reason that people believe Musk, of all people, can pull it out of the bag. Shareholders recently backed his $2.6 billion stock-based remuneration plan that represents a never-seen-before package for a CEO of a publicly-listed company, especially one that is already by far the biggest shareholder in Tesla.

In other words, Musk is all in. If there is anyone that can steer Tesla through the tough turns and over the difficult bumps ahead, and anyone who had a reason to do it, it is Elon Musk.